Macro – Europe

The eurozone feels the heat

Henk Potts, London UK, Market Strategist EMEA

Key points

  • Europe is experiencing an unprecedented energy crisis – and one that may get worse if enforced power cuts are enacted this winter
  • Household spending continues to feel the pinch with budgets squeezed by galloping prices and likely further interest rate rises to come
  • The European Central Bank has sent a clear message to markets that it’s determined to tame inflation – despite potentially sending the eurozone into recession
  • The recession risks are real for 2023, as a result of restrictions to Russian fuel supplies, labour disputes, and a central bank focused on fighting inflation

After a tough year for the eurozone economy, the prospect of energy shortages, a series of strikes leading to soaring wages, and battered consumer confidence means a recession is on the cards next year, with the bloc underperforming its developed world peers.

The devastating combination of the energy shock, record price pressures, and supply-chain disruptions to the crucial manufacturing sector, is suffocating activity in the eurozone. Regardless of the weakening economic backdrop, the European Central Bank (ECB) has been forced to hike interest rates in an effort to combat double-digit inflation. 

With the composite purchasing managers’ index (PMI) leading indicator now in contraction territory, the prospect of a recession in 2023 looms large. Energy security risks, tighter financial conditions, plunging domestic demand, pressures on industrial output, and reduced levels of investment point to a darker outlook. 

European energy crisis

The rationing of power and a proposed European Union (EU) embargo on Russian fuel supplies has sent a shockwave through energy markets, with European gas prices rocketing by fourfold. While Europe will remain vulnerable to further supply-side troubles, the immediate impact may be less than originally feared. 

European gas storage facilities are 90% full1 and the increase in liquefied natural gas (LNG) imports is helping to offset some of the supply shortfall. Nevertheless, as winter temperatures drop and demand lifts, the possibility of enforced cuts in consumption remains ever-present.

In order to further mitigate the effects of rising energy prices (see chart), EU officials have been trying to develop a package to curb electricity and gas prices, and shield the most vulnerable. 


Persistently higher power prices

The European Commission (EC) is aiming to lower prices through the development of a collective purchasing platform. In their opinion, mandatory joint purchases (which would force nominated energy companies to participate in the programme) would allow the bloc to take advantage of its greater bargaining power. 

A transition away from Europe’s reliance on Russian fossil fuels to green energy is at the heart of the REPowerEU plan2. Member states will be allowed to request additional funding through the Recovery and Resilience Facility3 in order to accelerate the investment required to achieve this objective by 2027. 

Despite policymaker’s best efforts, we expect that supply-side shortages and persistently higher energy prices will continue to impinge upon industrial production, household consumption and inflation projections through 2023.  

Limp consumer demand 

Europe’s recovery in domestic demand has been far less pronounced than in other western economies. Recent data has confirmed the slump in consumer confidence and slide in retail sales.  

Figures from the EC showed that consumer confidence in the EU plummeted in September to its lowest level on record4

This steep decline was driven by a significant fall across all its major components, including their outlook on their financial future, intention to make a major purchase, and expectations about the general economic situation. Eurostat figures show that retail sales in the 19 countries which share the euro fell 2% year-on-year in August5.  

Household consumption will likely remain constrained by the impact of elevated inflation on real income, a weaker labour market, and less willingness from consumers to draw upon savings accumulated during the pandemic. We forecast that private consumption will shrink by 0.1% in 2023 after growing by 3.9% in this year.

Eurozone workers feel the squeeze 

Eurozone labour markets have been relatively stable, nonetheless, we do expect unemployment to rise from 6.6% in September 2022 to 7.2% by the end of next year. The risk around aggressive pay increases is more of a concern. Unions in Europe remain very powerful and demands for higher wages could have hit both activity and inflation projections for 2023. 

In order to push through hefty wage settlements, unions have sparked a programme of industrial action. These negotiations take place at a fragile time for employees, as a cost-of-living squeeze continues to play out.  

If employers fail to settle with workers, the risk of more social disorder is likely to rise over the next year. On the other hand, if companies do significantly up wages, concerns over stoking price pressures would surface. 

Industrial production facing headwinds 

While euro area industrial production has grown faster than expected over the summer, sectors particularly vulnerable to the energy crisis, such as metal producers and chemicals, have come under pressure. Conversely, other sectors, such as electronics and motor vehicles, have worked through backlogs and rebuilt stocks as supply-chain disruptions ease. 

Next year, we expect Europe’s manufacturers to face the triple headwinds of elevated energy prices, softer domestic/external demand, and reduced investment. Gross investment is expected to come under pressure due to higher input and financing costs, climbing wages, and heightened uncertainty.  

Has inflation peaked? 

Euro area inflation accelerated in October, hitting a euro-era high of 10.7% year-on-year6. While energy and food were the main drivers, there has also been a noticeable pick up in services prices.  

We expect the harmonised index of consumer prices (HICP) to remain in double-digit territory into the start of next year, after which we forecast that price pressures will slowly moderate as a result of government intervention in energy markets, and weaker wholesale gas and electricity prices. 

Nevertheless, we continue to forecast that price pressures will remain elevated next year, averaging 5.7% (see table). 


ECB ups recession risks

The European Central Bank’s (ECB) Governing Council has sent a clear message to markets that they are determined to tame inflation, and normalise policy, despite potentially sending the eurozone into recession. Policymakers delivered an unprecedented 75 basis point (bp) rate hike at both the September and October policy meetings.  

Given the high, persistent, and broad-based nature of inflation, the aggressive hiking cycle may persist over the next few months. We forecast that rates will be lifted by 50bp at the December meeting, followed by 25bp increases at both the February and March ones. This would put the terminal rate at a higher-than-previously-forecast 2.5%. 

After concluding the rate hiking cycle, we expect the central bank to consider scaling down the reinvestment of maturing securities in its asset-purchase programme (APP). That said, the timing will depend on the depth of the recession and impact on financial stability.  

Bloc set to underperform

As outlined, Europe faces a plethora of economic challenges next year, yet price stability is the primary objective for policymakers. Inevitability, the cost of taming inflation will lead to a longer and deeper recession. We forecast that the eurozone will shrink by 0.8% in 2023, underperforming most advanced economies, led by Germany and Italy (see chart).


Related articles


Global Outlook 2023

As investors near the end of a tough year, full of twists and turns, our bumper Outlook 2023 takes a look at prospects for financial markets next year.